Using excel for business analysis

The majority of Excel users are self-taught, and therefore many users will oftenknow highly advanced Excel tools, yet fail to understand how to use them in thecontext of building a finan

Using Excel for Business Analysis

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Using Excel for Business Analysis

A Guide to Financial Modelling Fundamentals

DANIELLE STEIN FAIRHURST

John Wiley & Sons Singapore Pte Ltd.

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No part of this publication may be reproduced, stored in a retrieval system, or transmitted inany form or by any means, electronic, mechanical, photocopying, recording, scanning, orotherwise, except as expressly permitted by law, without either the prior written permission

of the Publisher, or authorization through payment of the appropriate photocopy fee to theCopyright Clearance Center Requests for permission should be addressed to the Publisher,John Wiley & Sons (Asia) Pte Ltd., 1 Fusionopolis Walk, #07-01, Solaris South Tower,Singapore 138628, tel: 65–6643–8000, fax: 65–6643–8008, e-mail: enquiry@wiley.com.This publication is designed to provide accurate and authoritative information in regard tothe subject matter covered It is sold with the understanding that the Publisher is not engaged

in rendering professional services If professional advice or other expert assistance is required,the services of a competent professional person should be sought Neither the author nor thepublisher is liable for any actions prompted or caused by the information presented in this book.Any views expressed herein are those of the author and do not represent the views of theorganizations he works for

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CHAPTER 1

What’s the Difference between a Spreadsheet and a

CHAPTER 3

CHAPTER 4

CHAPTER 5

CHAPTER 8

CHAPTER 10

CHAPTER 12

Bubble Charts 302

This book was written from my course materials compiled over many years of training

in analytical courses in Australia and globally—most frequently courses such asFinancial Modelling in Excel, Data Analysis & Reporting in Excel, and Budgeting &Forecasting in Excel, both as face-to-face workshops and online courses The commontheme is the use of Microsoft Excel, and I’ve refined the content to suit the hundreds ofparticipants and their questions over the years This content has been honed and refined

by the many participants on these courses, who are my intended readers This book isaimed at you, the many people who seek financial analysis training (either by attending

a seminar or self-paced by reading this book) because you are seeking to improve yourskills to perform better in your current role, or get a new and better job

When I started financial modelling in the early nineties, it was not calledfinancialmodelling—it was just “Using Excel for Business Analysis,” and this is what I’ve calledthis book It was only just after the new millennium that the termfinancial modellinggained popularity in its own right and became a required skill often listed on analyticaljob descriptions This book spends quite a bit of time in Chapter 1 defining themeaning of a financial model as it’s often thought to be something that is far morecomplicated than it actually is Many analysts I’ve met are building financial modelsalready without realising it, but they do themselves a disservice by not calling theirmodels, “models”!

However, those who are already building financial models are not necessarilyfollowing good modelling practice as they do so Chapter 3 is dedicated to the prin-ciples of best modelling practice, which will save you a lot of time, effort, and anguish

in the long run Many of the principles of best practice are for the purpose of reducingthe possibility of error in your model, and there is a whole section on strategies forreducing error in Chapter 4

The majority of Excel users are self-taught, and therefore many users will oftenknow highly advanced Excel tools, yet fail to understand how to use them in thecontext of building a financial model This book is very detailed, so feel free to skipsections you already know Because of the comprehensive nature of the book, much ofthe detailed but less commonly used content, such as instructions for the olderExcel 2003 users, has been moved to the companion website at www.wiley.com/go/steinfairhurst References to the content on the website, and many cross-references toother sections of the book, can be found throughout the manuscript

BOOK OVERVIEW

This book has 12 chapters, but these can be grouped into three parts Whilst they dofollow on from each other with the most basic concepts at the beginning, feel free tojump directly to any of the parts The first section—Chapters 1 to 3—addresses the

least technical topics about financial modelling in general, such as tool selection, modeldesign, and best practice.

The second section—Chapters 4 to 8—is extremely practical and hands-on Here Ihave outlined all of the tools, techniques, and functions in Excel that are commonlyused in financial modelling Of course it does not cover everything Excel can do, but itcovers the “must-know” tools

The third section—Chapters 9 to 12—is the most important in my view Thiscovers the use of Excel in financial modelling and analysis This is really where thebook differs from other “how-two” Excel books Chapter 9 covers some commonlyused techniques in modelling, such as escalation, tiering tables, and depreciation—how

to actually use Excel tools for something useful! Chapter 11 covers the several differentmethods of performing scenarios and sensitivity analysis (basically the wholepoint offinancial modelling to my mind!) Lastly, Chapter 12 covers the often-neglected task ofpresenting model output Many modellers spend days or weeks on the calculations andfunctionality, but fail to spend just a few minutes or hours on charts, formatting, andlayout at the end of the process, even though this is what the user will see, interact with,and eventually use to judge the usefulness of the model

ACKNOWLEDGEMENTS

This book would not have been written had it not been for the many people who haveattended my training sessions, participated in online courses, and contributed to theforums Your continual feedback and enthusiasm for the subject inspired me to writethis book and it was through you that I realised how much a book like this was needed.The continued support of my family made this project possible In particular, Mike

my husband for his unconditional commitment and to whom this book is dedicated, mychildren who give me such joy, as well as my remarkable parents and siblings who havealways inspired and encouraged me without question I would like to give a specialthanks to my ever-patient assistant Susan Wilkin for her dedication and diligencethroughout the project, Kurt Alexander for his steadfast enthusiasm, and to Joe Porteusfor keeping me on the right track

I hope you find the book both useful and enjoyable Happy modelling!

CHAPTER 1

What Is Financial Modelling?

experience there is quite a bit of confusion around what a financial model is exactly

A few years ago, we put together a Plum Solutions survey about the attitudes, trends,and uses of financial modelling, asked respondents “What do you think a financialmodel is?” Participants were asked to put down the first thing that came to mind,without any research or too much thinking about it I found the responses interesting,amusing, and sometimes rather disturbing

Some answers were overly complicated and highly technical:

approach designed to anticipate range of outcomes.”

operational and financial characteristics of a business and/or its activities.”

n “Tool(s) used to set and manage a suite of variable assumptions in order to predictthe financial outcomes of an opportunity.”

information, analysis, and insight to be drawn out and supported by quantitativefacts.”

reporting required to be informed, up-to-date, and able to track finances accuratelyand plan for the future.”

Some philosophical:

Some incorrect:

n “It is all about putting data into a nice format.”

make your life easier.”

Some ridiculous:

Some honest:

n “I really have no idea.”

And some downright profound:

Whilst there are many other (often very complicated and long-winded) definitionsavailable from different sources, but I actually prefer the last, very broad, but accuratedescription: “a complex spreadsheet.” Whilst it does need some definition, a financial

As long as a spreadsheet has inputs and outputs, and is dynamic and flexible—I’mhappy to call it a financial model! Pretty much the wholepoint of financial modelling isthat you change the inputs and the outputs This is the major premise behind scenarioand sensitivity analysis—this is what Excel, with its algebraic logic, was made for!Most of the time, a model will contain financial information and serve the purpose

of making a financial decision, but not always Quite often it will contain a full set offinancial statements: profit and loss, cash flow, and balance sheet; but not always.According to the more staid or traditional definitions of financial modelling, thefollowing items would all most certainly be classified as financial models:

n A five-year forecast showing profit and loss, cash flow, and balance sheet

n Investment analysis for a joint venture

But what about other pieces of analysis that we perform as part of our roles? Can thesealso be called financial models? What if something does not contain financial information

at all? Consider if you were to produce a spreadsheet for the following purposes:

n An actual-versus-budget monthly variance analysis that does not contain scenariosand for which there are no real assumptions listed

n A risk assessment, where you enter the risk, assign a likelihood to that risk, andcalculate the overall risk of the project using probability calculations This does notcontain any financial outputs at all

headcount, quality, customer numbers, call volume, and so on Again, there arefew or no financial outputs

See the section on the “Types and Purposes of Financial Models” later in thischapter for some more detail on financial models that don’t actually contain financialinformation

Don’t get hung up on whether you’re actually building something that meets thedefinition of a financial model or not As long as you’ve got inputs and outputs thatchange flexibly and dynamically you can call it a financial model! If you’re using Excel

to any extent whereby you are linking cells together, chances are you’re alreadybuilding a financial model—whether you realise it or not The most important thing is

that you are building the model (or whatever it’s called!) in a robust way, following theprinciples of best practice, which this book will teach you.

Generally, a model consists of one or more input variables along with data andformulas that are used to perform calculations, make predictions, or perform anynumber of solutions to business (or non-business) requirements By changing the values

of the input variables, you can do sensitivity testing and build scenarios to see whathappens when the inputs change

Sometimes managers treat models as though they are able to produce the answer toall business decisions and solve all business problems Whilst a good model can aidsignificantly, it’s important to remember that models are only as good as the data theycontain, and the answers they produce should not necessarily be taken at face value

“The reliability of a spreadsheet is essentially the accuracy of the data that itproduces, and is compromised by the errors found in approximately 94% of spread-

assumptions, and the way it’s built Someone who has had some experience in buildingmodels will realise that they must be treated with caution Models should be used asone tool in the decision-making process, rather than the definitive solution

WHAT’S THE DIFFERENCE BETWEEN A SPREADSHEET

AND A FINANCIAL MODEL?

Let me make one thing very clear: I am not partial to the use of the wordspreadsheet; infact you’ll hardly find it used at all in this book

I’ve often been asked the difference between the two, and there is a fine line ofdefinition between them In a nutshell, an Excel spreadsheet is simply the medium that

we can use to create a financial model

At the most basic level, a financial model that has been built in Excel is simply acomplex spreadsheet By definition, a financial model is a structure that contains inputdata and supplies outputs By changing the input data, we can test the results of thesechanges on the output results, and this sort of sensitivity analysis is most easily done in

an Excel spreadsheet

One could argue then, that they are in fact the same thing; there is really no ference between a spreadsheet and a financial model Others question if it reallymatters what we call them as long as they do the job? After all, both involve puttingdata into Excel, organising it, formatting, adding some formulas, and creating someusable output There are, however, some subtle differences to note

dif-1 “Spreadsheet” is a catchall term for any type of information stored in Excel,including a financial model Therefore, a spreadsheet could really be anything—

a checklist, a raw data output from an accounting system, a beautifully laid outmanagement report, or a financial model used to evaluate a new investment

2 A financial model is more structured A model contains a set of variableassumptions, inputs, outputs, calculations, scenarios, and often includes a set of

1Ruth McKeever, Kevin McDaid, Brian Bishop, “An Exploratory Analysis of the Impact ofNamed Ranges on the Debugging Performance of Novice Users,” European Spreadsheet RisksInterest Group: 2009 Available at arxiv.org/abs/0908.0935

standard financial forecasts such as a profit and loss, balance sheet, and cash flow,which are based on those assumptions.

3 A financial model is dynamic A model contains variable inputs, which, whenchanged, impact the output results A spreadsheet might be simply a report thataggregates information from other sources and assembles it into a useful presen-tation It may contain a few formulas, such as a total at the bottom of a list ofexpenses or average cash spent over 12 months, but the results will depend ondirect inputs into those columns and rows A financial model will always havebuilt-in flexibility to explore different outcomes in all financial reports based onchanging a few key inputs

4 A spreadsheet is usually static Once a spreadsheet is complete, it often becomes astand-alone report, and no further changes are made A financial model, on theother hand, will always allow a user to change input variables and see the impact

of these assumptions on the output

5 A financial model will use relationships between several variables to create thefinancial report, and changing any or all of them will affect the output For

come into play, and the end user can explore different mixes of all three to see theresults and decide which reflects their business model best

6 A spreadsheet shows actual historical data, whereas a financial model containshypothetical outcomes A by-product of a well-built financial model is that we caneasily use it to perform scenario and sensitivity analysis This is an importantoutcome of a financial model What would happen if interest rates increase by half

a basis point? How much can we discount before we start making a loss?

In conclusion, a financial model is a complex type of spreadsheet, whilst aspreadsheet is a tool that can fulfill a variety of purposes—financial models being one.The list of attributes above can identify the spreadsheet as a financial model, but insome cases, we really are talking about the same thing Take a look at the Excel filesyou are using Are they dynamic, structured, and flexible, or have you simply created astatic, direct-input spreadsheet?

TYPES AND PURPOSES OF FINANCIAL MODELS

Models in Excel can be built for virtually any purpose—financial and non-financial,business- or non-business related—although the majority of models will be financialand business-related The following are some examples of models that do not capturefinancial information:

status, likelihood, impact, and mitigation Conditional formatting is often grated to make a colourful, interactive report

critical path schedules and even Gantt charts (See the next section in this chapter,

“Tool Selection,” for an analysis of whether Microsoft Project or Excel should beused for building this type of project plan.)

n KPIs and Benchmarking: Excel is the best tool for pulling together KPI and metricsreporting These sorts of statistics are often pulled from many different systems andsources, and Excel is often the common denominator between different systems.

dash-board is a conglomeration of different measures (sometimes financial but oftennot), which are also often conveniently collated and displayed as charts and tablesusing Excel

by focusing on the operational, marketing, and developmental performance of theorganisation as well as financial measures A scorecard will display measures such

as process performance, market share or penetration, and learning and skillsdevelopment, all of which are easily collated and displayed in Excel

As with many Excel models, most of these could be more accurately created andmaintained in a purpose-built piece of software, but quite often the data for these kinds

of reports is stored in different systems, and the most practical tool for pulling the datatogether and displaying it in a dynamic monthly report is Excel

Although purists would not classify these as financial models, the way that theyhave been built should still follow the fundamentals of financial modelling bestpractices, such as linking and assumptions documentation How we classify thesemodels is therefore simply a matter of semantics, and quite frankly I don’t think what

we call them is particularly important! Going back to our original definition offinancial modelling, it is a structure (usually in Excel) that contains inputs and outputs,and is flexible and dynamic

TOOL SELECTION

In this book we will use Excel exclusively, as that is most appropriate for the kind offinancial analysis we are performing when creating financial models I recommendusing plain Excel, without relying on any other third-party software for several reasons:

n No extra licenses, training, or software download is required

n Little training is required, as most users have some familiarity with the product—which means other people will be able to drive and understand your model

n It is a very flexible tool If you can imagine it, you can probably do it in Excel(within reason, of course)

n Excel can report, model, and contrast virtually any data, from any source, all inone report

n But most importantly, Excel is commonly used across all industries, countries, andorganisations What this means to you is that if you have good financial modellingskills in Excel, these skills are going to make you more in demand—especially ifyou are considering changing industries or roles or getting a job in another country.Excel has its limitations, of course, and Excel’s main downfall is the ease withwhich users can make errors in their models Therefore, a large part of financialmodelling best practice relates to reducing the possibility for errors See Chapter 3,

“Best Practice Principles of Modelling,” and “Error Avoidance Strategies” in Chapter 4for details on errors and how to avoid them.

Is Excel Really the Best Option?

Before jumping straight in and creating your solution in Excel, it is worth consideringthat some solutions may be better built in other software, so take a moment tocontemplate your choice of software before designing a solution There are many otherforms of modelling software on the market, and it might be worth consideringother options besides Excel There are also a number of Excel add-ins provided by thirdparties that can be used to create financial models and perform financial analysis Thebest choice depends on the solution you require

The overall objective of a financial model determines the output as well as thecalculations or processing of input required by the model Financial models are built forthe purpose of providing timely, accurate, and meaningful information to assist in thefinancial decision making process As a result, the overall objective of the modeldepends on the specific decisions that are to be made based on the model’s output

As different modelling tools lend themselves to different solutions or output, beforeselecting a modelling tool it is important to determine precisely what solution isrequired based on the identified model objective

Evaluating Modelling Tools

Once the overall objective of the model has been established, a financial modelling toolthat will best suit the business requirements can be chosen

To determine which financial modelling tool would best meet the identifiedobjective, the following must be considered:

decisions to be made

the number of interdependent variables and the relationships between them

n The complexity of calculations or processing of input to be performed by the model

manipulate the model without the assistance of a specialist

n The cost versus benefit set off for each modelling tool

As with all software, financial modelling programs can either be purchased as apackage or developed in-house Whilst purchasing software as a package is a cheaperoption, in a very complex industry, in-house development of specific modelling softwaremay be necessary in order to provide adequate solutions In this instance, one would need

to engage a reputable specialist to plan and develop appropriate modelling software.Which package you choose depends on the solution you require A database orcustomer relationship management (CRM) data lends itself very well to a databasesuch as Microsoft Access, whereas something that requires complex calculations, such

as those in many financial models, is more appropriately dealt with in Excel

Excel is often described as a Band-Aid solution, because it is such a flexible toolthat we can use to perform almost any process—albeit not as fast or as well as fully

customised software, but it will get the job done until a long-term solution is found:

“ spreadsheets will always fill the void between what a business needs today and theformal installed systems ”2

Budgeting and Forecasting

Many budgets and forecasts are built using Excel, but most major general ledger tems have additional modules available that are built specifically for budgeting andforecasting These tools provide a much easier, quicker method of creating budgetsand forecasts that is less error-prone than using templates However, there aresurprisingly few companies that have a properly integrated, fully functioning budgetingand forecasting system, and the fallback solution is almost always Excel

sys-There are several reasons why many companies use Excel templates over a fullbudgeting and forecasting solution, whether they are integrated with their generalledger system or not

n Integration with the general ledger system means a large investment in a particularmodelling system, which is difficult to change later

n Even if a system is not in place, invariably some analysis will need to be undertaken

in Excel, necessitating at least part of the process to be built using Excel templates.Microsoft Office Tools: Excel, Access, and Project

Plain-vanilla Excel (and by this I mean no add-ins) is the most commonly used tool Seethe next section for a review of some extra add-ins you might like to consider How-ever, there are other Microsoft tools that could also serve to create the solution.Microsoft (MS) Access is probably the closest alternative to Excel, and quite oftensolutions are built in Excel when, in fact, Access is the most sensible solution.There is often some resistance to using Access, and it is becoming less popular than

it was a decade or so ago Prior to the release of Excel 2007, Excel users were restricted

to only 65,000 rows, and many analysts and finance staff used Access as a way to getaround this limit With now over 1.1 million rows, Excel is able to handle a lot moredata, so there is less need for the additional row capacity of Access However, Access isstill worth some consideration

Advantages of Excel

n Excel is included most basic Microsoft packages (unlike Access, which often needs

to be purchased separately) and therefore comes as standard on most PCs Excel ismuch more flexible than Access and calculations are much easier to perform

n It is generally faster to build a solution in Excel than in Access

intuitive This means it is quicker and easier to train staff in Excel

n It is very easy to create flexible reports and charts in Excel

2Mel Glass, David Ford, Sebastian Dewhurst, “Reducing the Risk of Spreadsheet Usage

A Case Study,” European Spreadsheet Risks Interest Group: 2009 Available at arxiv.org/abs/0908.1584

n Excel can report, model, and contrast virtually any data, from any source, all inone file.

Access has difficulty with

Advantages of Access

rows and 256 columns, and Excel 2007 and 2010 are limited to around 1.1 millionrows and 16,000 columns Access’s capability is much larger, and it also has agreater memory storage capacity

n Data is stored only once in Access, making it work more efficiently

n Due to Access’s lack of flexibility, it is a harder for users to make errors

users to enter data

MS Project is specifically for creating project plans and associated componenttasks, assigning resources to those tasks, tracking progress, managing budgets, andmonitoring workloads The user can also create critical path schedules and Gantt charts.Because the program handles costs, budgets, and baselines quite well, Project could

be considered a viable alternative to a financial model, if the purpose of the model weresimply to create an actual-versus-budget tracking report In fact, as with most purpose-built software, if your aim is to track and monitor a project, Project is a far superior option

to Excel Of course creating a project plan and even a Gantt chart is certainly possible inExcel, although it will take longer, and be far more prone to error than Project There aremany reasons, however, why users will opt to use Excel for a project plan over Project:

n Project is not included in any of the Office suites and therefore needs to be chased separately

may not be able to use Project due to lack of skills

n For a reasonably small project it’s probably not worth the trouble; it’s simpler tojust work it up in Excel

In summary, the choice between Excel and Project really depends on the size,scope, and complexity of the project plan model you are building Bear in mind ofcourse that there are many other pieces of project planning software besides Project onthe market!

Excel Add-Ins Add-ins are programs that add optional commands and features to Excel.There are many add-ins on the market that have been developed specifically for thepurpose of financial modelling For more complex calculations or processing of input,

it may be useful to activate or install one or more add-ins, especially tools such asSolver, which are included in your MS Excel licence Bear in mind that other users willprobably not have add-ins enabled, so they will not be able to see how your model hasbeen created or calculated

Excel add-ins can be categorised according to source:

once Excel has been installed

be used

n Custom add-ins created by third parties that must be installed before they can beused: Component Object Model (COM) add-ins, Visual Basic for Applications(VBA) add-ins, Automation add-ins, or DLL add-ins

Excel add-ins from all sources can be used to perform a variety of tasks that assist

in the financial modelling process These add-ins can be broadly defined as:

n Audit tools

The most commonly used add-ins are the Analysis ToolPak and Solver, which arestandard add-in programs that are available when you install Microsoft Office orExcel They are included in the program but are disabled by default, so if you want touse them, you need to enable them

Prior to the release of Excel 2007 the only way to access certain functions (e.g.,

¼EOMONTH and ¼SUMIFS) in Excel 2003 was to download the Analysis ToolPak.However, these functions are now standard in Excel 2007 and later, so the AnalysisToolPak is now less commonly used

Other features in the Analysis ToolPak are tools like Data Analysis ToolPak, whichhas some powerful statistical and engineering functions not commonly used in financialmodelling Solver, however, is an extremely useful but rather advanced tool for cal-culating optimal values in financial modelling

Audit Add-Ins Audit add-ins for Excel are used to ensure the accuracy of data and culations within a spreadsheet or workbook They can very quickly identify formulaerrors by looking at inconsistent formulas, comparing versions, and getting to thebottom of complex named ranges There are several custom add-ins available both fromMicrosoft and other parties that will facilitate accuracy by performing formula inves-tigations, precedent/dependent analysis, worksheet analysis, and sensitivity reporting.Whilst they can assist with checking for formula errors, there are many other types

cal-of errors that can be easily overlooked, and using these add-ins can provide a falsesense of security See the section on “Error Avoidance Strategies” in Chapter 4 for moredetail

Integration Add-Ins Integration add-ins allow information from the financial reportingsystem to be transferred into Excel for further analysis, or data stored in Excel to betransferred into the financial reporting system These are often used for the purpose of:

pur-poses of reporting and analysis Many management reports are built in Excel, andextract up-to-date data directly from the general ledger system into the reports

n Loading information in the form of journal entries back into the general ledgersystem Data is often manipulated in Excel, and then loaded into the generalledger as a journal For example, if an invoice needs to be split between differentdepartments based on headcount allocation, this calculation might be done inExcel, split to departments in the journal, and loaded into the general ledgersystem.

The Final Decision

The more sophisticated a financial model is, the more expensive it is to maintain It istherefore best to use a model with the lowest possible level of sophistication needed toprovide a specific solution For this reason, purchasing a software package, provided itcan provide the desired solution, would usually be advisable

Once the decision has been made to purchase a software package, it must be mined which package will provide the best solution as certain solutions may be betterprovided by particular software packages

deter-There are many forms of software and Excel add-ins on the market that can beused to create financial models However, provided that it can provide an adequatesolution, we recommend using plain Excel, as it is easy to use and no extra licenses,training, or software downloads are required If additional functionality is needed,Excel add-ins may be considered

WHAT SKILLS DO YOU NEED TO BE A GOOD FINANCIAL MODELLER?

When you decide your financial models are not as good as they should be, should youimmediately take an advanced Excel course? Whilst this is helpful, there’s a great dealmore to financial modelling than being good at Excel!

When considering the skills that make up a good financial modeller, we need todifferentiate between conceptual modelling, which is to have an understanding of thetransaction, business, or product being modelled, and spreadsheet engineering, which isthe representation of that conceptual model in a spreadsheet Spreadsheet skills arereasonably easy to find, but a modeller who can understand the concept of the purpose

of the model and translate it into a clear, concise, and well-structured model ismuch rarer

People who need to build a financial model sometimes think they need to becomeeither an Excel super-user or an accounting pro who knows every in and out ofaccounting rules I’d argue you need a blend of both, as well as a number of other skills,including some business common sense!

Spreadsheet and Technical Excel Skills

It’s very easy for financial modellers to get bogged down in the technical Excel aspects

of their model, get carried away with complex formulas, and not focus on key level, best-practice procedures, such as error-checking strategies and model stress-testing

high-Excel is an incredibly powerful tool, and almost no single high-Excel user will have theneed or desire to utilise most of the functionality this program offers As with most

software, the 80/20 rule applies: 80 percent of users use only 20 percent of thefeatures—although some would argue that 95 percent of Excel users use only 5 percent

of the features! Still, there are those select few who understand every in and out of Excel,every single function, and work out how to do practically anything in Excel Do youneed to have this level of Excel skill to become a good financial modeller? Unfortu-nately, having great software skills doesn’t always help when it comes to applying them

to a specific area of business Realise that Excel is used in several capacities, so being anExcel super-user doesn’t automatically mean you’ll be a super financial modeller Thebest financial models are clear, well structured, flexible, and dynamic; they are notalways the biggest and most complicated models that use the most advanced tools andfunctions! Many of the best financial models use only Excel’s core functionality.Having said that, to be a good financial modeller, you do need to know Excelexceptionally well Those people who maintain that you don’t need good Excel skills to

be a financial modeller are usually those with weak Excel skills You should be building

a superb model using simple and straightforward tools because you’ve chosen to makeyour model clear and easy to follow, not because that’s all you know how to do! Youdon’t have to be a super-user—the 99th percentile in Excel knowledge—but you mustcertainly be above average A complex financial model might use features in Excel thatthe everyday user doesn’t know The best financial model will always use the solutionthat is the simplest tool to complete the task (as simple as possible and as complex asnecessary, right?), so the more familiar you are with the tools available in Excel, theeasier it will be An array formula or a macro might be the only way to achieve whatyou need to achieve, but a simpler solution may well be—and often is—superior Youmight also need to take apart someone else’s model, which uses complex tools, and it’svery difficult to manipulate an array formula or a macro if you’ve never seen onebefore! So, if you are considering a career as a financial modeller (as I assume you are)improving your Excel knowledge is an excellent place to start

EXAMPLES OF TECHNICAL EXCEL SKILLS QUESTIONS

or a SUMIF?

n How do I insert or hide a sheet and then protect it so that the user can’t access it?

Industry Knowledge

One of the fantastic things about financial modelling is that it is applicable across somany different industries Good financial modelling skills will always stand you ingood stead, no matter which industry or country you are working in! Financialmodelling consultants or generalists will probably work in many different industriesduring their careers and be able to build models for different products and services.They will probably not be experts in the intricacies of each industry, however, andthat’s why it’s important for a financial modelling generalist to consult carefully with

the subject matter expert for the inputs, assumptions, and logic of the financial model.Don’t be afraid to ask lots and lots of questions if the details are not absolutely clear.It’s quite likely that the person who has commissioned the model hasn’t actuallythought through the steps, inputs, assumptions, and even what the outputs should looklike, until you ask the right question.

Financial modellers working within an organisation, however, usually becomeexperts in their own industry or domain, and will become very familiar with theminutiae of how financial models for that industry should be designed, and whichassumptions should be used

Financial modelling consultants are very careful to transfer responsibility for theassumptions to the end user, which is a very sensible course of action The personbuilding the model is often not the one who has commissioned it or the person who isactually using it Model builders are often not overly familiar with the product or eventhe organisation, and they cannot (and should not) take responsibility for the inputs.(See the section “Document Your Assumptions” in Chapter 3 for greater detail on theimportance of documentation of assumptions.)

For example, when building a pricing model, the modeller needs to understand theproduct and how the costs and revenue work Experience with regulatory constraintswill help the modeller to understand the basis of regulation and its components (e.g.,cost building blocks, cost index, revenue cap, weighted average price cap, maximumprices, etc.) Understanding of economic concepts, such as efficient cost calculation,return on and of a regulatory asset base, operating costs and working capital, long-runversus short-run marginal costs, and average costs, are other examples of industryknowledge that is useful for the financial modeller

EXAMPLES OF INDUSTRY KNOWLEDGE

a competent Excel user As with the other modelling skills, you don’t need a top level ofaccounting knowledge to build a financial model In fact, financial models are often

relatively straightforward from an accounting standpoint You certainly do not need to

be a qualified accountant to become a financial modeller, although a good standing of accounting and knowledge of finance certainly help

under-There are some situations where industry knowledge and accounting are required forfinancial modelling For example, in manufacturing or, particularly, in the oil and gasindustry, the modeller needs to know whether FIFO (first in, first out) or LIFO (last in,first out) accounting is being used, as this has a big impact on the way that inventory

is being modelled A financial modeller who has never worked in these industriesmay not have ever heard of FIFO and LIFO, and would probably have no idea how tomodel it

EXAMPLES OF ACCOUNTING KNOWLEDGE

Business Knowledge

A modeller with wide-ranging business experience is well equipped to probe for the factsand assumptions that are critical for building a financial model This is probably the mostdifficult skill to teach, as it’s most easily picked up by working in a management role.Business acumen is particularly important when commissioning, designing, andinterpreting a financial model When creating the model, the modeller needs to con-sider the purpose of the model What does the model need to tell us? Knowing thedesired outcome will assist with the model’s build, design, and inputs If, for example,

we are building a pricing model, we need to consider the desired outcome; normally,the price we need to charge in order to achieve a certain profit margin What is anacceptable margin? What costs should we include? What cost will the market bear?Modellers should also have an understanding of economic concepts, such as efficientcosts and how these are calculated, an expected return on an asset base, operating costsand working capital, or long-run versus short-run marginal costs

Of course the answers to these questions can be obtained from other people, but amodeller with good business sense will have an innate sense of how a model should bebuilt, and what is the most logical design and layout to achieve the necessary results

EXAMPLES OF BUSINESS KNOWLEDGE

n What is cost of capital and how does that affect a business case?

n What does the internal rate of return (IRR) mean and what is an acceptable rate?

Aesthetic Design Skills

This is an area that many modellers and analysts struggle with, as aesthetics simply donot come naturally to left-brain thinkers like us We are mostly so concerned withaccuracy and functionality that we fail to realise that the model looks—and I’m notgoing to mince words here—ugly! Although it’s just a simple matter of taking our timewhen formatting, most of us could not be bothered with such trivial details as makingmodels pretty, and consequently most models I see use the standard gridlines, font, andblack-and-white colouring that are Excel defaults I’m certainly not suggesting that youembellish your models with garish colours, but you should take some pride in yourmodel See the section on “Bulletproofing Your Model” in Chapter 7 for some ideas onhow to remove gridlines and change some of the standard settings so that your modellooks less like a clunky spreadsheet and more like a reliable, well-crafted model you’vetaken your time over Research shows that users place greater faith on models withaesthetic formatting than those without, so one of the fastest and easiest ways to giveyour model credibility is to simply spend a few minutes on the colours, font, layout,and design

Some aesthetic formatting is critical for the functionality and to avoid error (seesection on “Error Avoidance Strategies” in Chapter 4), but mostly it adds credibilityand makes your model easier to work with

Models can become complex very quickly and without a well-planned design theycan be unintelligible Some basic components of a model should be a cover sheet,instructions, and clearly labelled inputs, outputs, workings, and results For extremelylong and complex models with many sheets, a hyperlinked table of contents is also avaluable addition to help the user navigate the model

Communication and Language Skills

This is also an area that we left-brain thinkers are not always good at Some analystslike to lock themselves away, working on spreadsheets without communicating withother people If this is your tendency, then you might need to consider whetherfinancial modelling is a good career choice for you, because there is a surprisingamount of human interaction required for most financial modellers

assumptions and inputs often need to be communicated verbally or in writing.People in various parts of the business should be involved in order to check theaccuracy and appropriateness of inputs for inclusion in a model Stakeholders willoften query the assumptions or the way they have been used and provide extremelyvaluable insight for modellers (particularly for a consultant or modeller with littleindustry or product knowledge) Performing this task well is a critical step in themodelling process

gathering and collating data than actually building the model Holders of mation can be guarded about giving access to data, sometimes irrationally, butoften it’s because they’ve had bad experiences in the past This can occur whensomeone provides estimates off the record, and later discovers that those numbershave been used in budgets or other documents to which they are held accountable

infor-So, people can be understandably reticent about providing data when requested for

an ad hoc project such as a financial model A modeller with good communicationskills will be able to dig, delve, and coax the information out of them!

hear about the financial implications of the project from the person who actuallybuilt the model, and so modellers are sometimes required to present the key out-comes to a board or executive committee Being able to distill a 30-megabyte,extremely complex financial model that contains 20 tabs and took you six weeks tobuild, into three PowerPoint slides and a six-minute summary presentation can bequite a challenge!

n Client Skills: Whether you are a consultant or an in-house employee, working wellwith clients is a useful skill Even in-house modellers have clients; every person youwork with or for should be considered a client and treated with the same respectand consideration as though they were paying your bill

In all of these interactions with other people, financial modellers must show fidence in their model Build the model to the best of your ability Use best practices,check for errors, and follow a good and logical thought process, so that when you present

con-or discuss your model, you can do so in a way that exudes absolute confidence Doing soreduces questions about the accuracy, usefulness, and validity of your model Be honestabout the fallibility of your model and its known shortcomings (let’s face it, no model isperfect), but be confident that you have built it to best-practice standards within thelimitations of time, data, or scope This will serve to increase your model’s credibility,building your reputation within your company, and, of course, enhancing your career!Numeracy Skills

Financial models, of course, have a significant mathematical component, and peoplewith good numeracy skills are best suited to it Solid math skills can be particularlyuseful in error-checking and sense-checking The ability to make rough estimatesquickly means they will be able to spot errors more easily If we sell 450 units at $800each, will our sales revenue be $3.6 m, or $360,000? If we’ve made a calculation error,the numerate modeller will pick up the mistake much more quickly

The numerate modeller will also have a gut feel for differentiating between criticalassumptions that need further verification, and input that is insignificant or immaterial

to the model The less-numerate modeller will have to test it manually, and will probablyend up with the same result, but it will take longer!

General numeracy is a skill that is difficult to teach, and one that can be easilytested for in the recruitment process Experience working with models over timecan drastically improve these skills as the modeller who is less numerate will learnways to compensate through error-testing, and these techniques will become acquired,innate habits

Ability to Think Logically

Modelling is often like programming, and complex logic needs to be interpreted intothe language of Excel so that the program can understand and create the modeller’sexpected results For example, if we want to show a value, but only if the cell being

tested is in the future, we would vocalise it by saying: “Show me the value, but only ifthe test cell is greater than or equal to today’s date.” The way that we need to translatethis into Excel’s language is to use the formula:

¼IF(test_cell.¼today,value,0)

Logic is also critical for model layout, design, and the use of assumptions in culations The issue of timing in annual models is one that I use often when demon-strating logic in my training workshops If we are estimating the revenue for a newinsurance product, and the assumption is that we acquire 30,000 customers every year,

cal-we can’t assume revenue for the full 30,000 customers, as not all of them will begin onthe very first day of Year 1 Customers will be acquired gradually throughout the year,

so we need to take an average in order to calculate revenue This is an example of how

it is very easy to get logic wrong, and overestimate revenue by a substantial amount.Logic is one of those analytical skills that is very difficult to teach, but modellers whohave made a logic error (like the one illustrated above) learn quickly from their mistakesand are quite careful to use clear, well-documented logic for others to follow and check

THE IDEAL FINANCIAL MODELLER

In general, most modellers have at least some of the aforementioned skills, and at times

it is necessary to consult specialists in order to create a successful financial model.Having read the section on the skills that you need to be a good financial modeller, youshould have a fairly good idea about which areas you are lacking in Once you haveidentified these areas, you can work to improve them and liaise with other specialists toensure that your model is not lacking as a result of your weaknesses

What financial modellers bring to the table is a combination of skills First, they knowExcel well enough to be able to choose the simplest and most functional tool to build amodel They can create a pivot table, array formula, or macro (but only when necessary,

of course!); use a simple or complex nested formula; and choose the best technical tool

to perform a scenario analysis They also understand all the relevant business andaccounting principles At the end of the day, the balance sheet has to balance, and theending cash on your cash flow statement needs to tie to the balance sheet, for example.The ideal financial modeller brings a unique combination of skills that neither anExcel guru nor an accounting whiz possesses He or she understands sensitivity andrelationships between variables, how fluctuations in inputs will impact the outcomes, andhow this needs to be modelled in Excel A financial modeller can also take a step back andrealise what the ultimate goal of the model should be Are we building a model for in-houseuse, or to present to investors? Do we need a valuation, a variance analysis, a nice sum-mary, or a detailed, month-by-month profit-and-loss report? The financial modeller cantake information, build an Excel model that is technically correct from an accountingstandpoint, set up the model, and ultimately reflect what the business is looking to achieve.What’s the Typical Background for a Financial Modeller?

A key problem in the financial modelling industry is that modelling is often incorrectlyconsidered a junior task, and is often given to inexperienced graduate analysts whoundoubtedly have good Excel skills, but simply do not have the depth of business

experience to create good financial models If a modeller is able to tick all of the aboveboxes (i.e., good financial skills, good communicator, able to resolve ambiguity), he orshe is likely to quickly move into a more senior position to execute more managementresponsibilities and spend less time building financial models.

Most financial modellers come from a finance background and have graduallybeen exposed to industry knowledge They often become specialists in a field, picking

up business acumen, communication skills, and logic along the way Quite oftenengineers, project managers, construction specialists, or even scientists who arerequired to build their own financial models end up pursuing a career in financialmodelling They have the industry and product knowledge and are able to learn theExcel skills, but may struggle with the finance side of things Some would argue that it

is easier to teach an engineer or scientist financial skills than it is to teach a financialaccountant about the industry, but I think both have a tough job Every modellerwill have strengths and weaknesses, but a good financial modeller will span differentskill sets and will have a little bit of everything

Training Courses

As a specialist financial modelling consultant and trainer, I spend a lot of my timerunning training courses and, consequently, many people expect me to be a firmadvocate of the face-to-face training workshop, right? Not necessarily I’ve come underfire from my training partners in the past for publicising this opinion, but I’m notentirely convinced that going on a training course is always the best option for someonekeen to improve their financial modelling skills

Excel is the backbone to any custom-built financial model, and as discussed in theprevious section, one of the core attributes of a financial modeller is to have goodtechnical Excel skills When struggling with financial models, some managers’ firstreaction is to send their staff on an advanced Excel course to improve their modellingskills However, with training budgets under constant scrutiny, you really need to makesure that you get the best value out of your training options Is a training course reallywhat you need?

When considering an advanced Excel course, there are a few points you shouldconsider

n As financial modellers, our use of Excel is quite narrow I know it’s hard for us toconceive, but there is a whole world of Excel outside the finance industry! Sta-tisticians, database programmers, and engineers, to name a few, are able to useExcel’s advanced functions to create non-financial spreadsheets Most advancedExcel courses are very broad, and will cover functions and capabilities that do notapply to your needs as a financial modeller You may learn a few tricks, but thetime and money spent could be invested elsewhere

n Research shows that a large percentage of the skills learned in training courses are notretained Will you really remember everything that you learn? A programme ofcontinuous, applied learning is often more effective than an intensive training course

the logic behind a financial model are more important than building in complexformulas and, for the most part, you will want to keep formulas as simple aspossible

Alternatives to Attending a Training Course Other options to improve your financialmodelling skills without going on an advanced Excel course include:

n Read a book! Buying this book is a great start You’ll still have it to refer to whenthe excitement and enthusiasm you felt after completing a training course are longgone, and you’re back to struggling with building your financial models

can always learn from the techniques of others

n Read, use, and dissect other people’s models Sometimes the best way to learn is to seewhat someone else has done Try taking someone else’s model apart and see how he

or she built it It’s probably best to use your company’s models, but if you don’t haveaccess to those, take a look at some of the sample models provided on this book’scompanion website, which can be found at www.wiley.com/go/steinfairhurst

n Read specialist financial modelling publications or subscribe to e-mail newslettersabout using Excel They often contain useful articles about specific techniques andtips that can enhance your skills Getting a short e-mail tip every day is much moreeffective than reading many all at once You’ll retain the information better in bite-size pieces

convinced that there must be an easier way to do something, there usually is!Chances are that others have had the same problem in the past and, if you’re lucky,they’ve documented it as a blog post There are some fantastic, publicly availableonline resources including tutorials, articles, blogs, forums, and videos specialising

in Excel and financial modelling that can be used at your convenience rather thantaking an entire day or two to attend a course You will find links to some of myfavorite websites and online resources listed on the companion website at www.wiley.com/go/steinfairhurst

Select the Right Training Option for You The strategies outlined here are great for tinually improving your Excel and financial modelling skill set, and they certainlywon’t break the budget, but what if you really need to give your skills a quick boost toget you ready for an upcoming project? There are a number of options available:

con-n Try to find a course specifically aimed at Excel for financial modellers, and—evenbetter—find one dedicated to your industry Although good financial modellingskills are relevant across many different industries, there is nothing like specialisedtraining dedicated to the modelling issues inherent in your own industry In recentyears, many more specialist financial modelling courses have become available,especially in major cities

n If your company is able to arrange a group in-house training course, this will beeven better, as you may be able to learn with the templates and models actuallyused within your organisation You also have the added advantage of choosing atime and location that suit you

n If you can afford a private session, this is the most convenient and time-efficientmethod, as you can ask questions and cover only topics that are useful toyou Many specialist training companies provide Excel one-on-one mentoringsessions

Do You Really Need an Advanced Excel Course?

It’s true that “you don’t know what you don’t know,” and so some people go ontraining courses because they want to make sure there isn’t something about the subjectthat they are missing Having heard or seen something in a training course gives youexposure to something that you might never have heard about, but if it’s simplyinspiration you’re after, a good newsletter might well suffice (and be a lot cheaper)!You might learn a few tricks on a course, but most people have got to think reallyhard before spending the money and taking a day or two out of their schedules tocommit to training workshops There is no question that face-to-face workshops arevery effective; for many people, they are the best way to learn However, I wouldrecommend that potential attendees exhaust the available blogs, forums, and news-letters first

In summary, an advanced Excel course would certainly benefit those who plan onextensively using Excel in their role for multiple purposes However, if your mainobjective is to become an expert financial modeller, focus instead on mastering the fewtools you need—such as logic and methodology—either in a course or via anothermedium, rather than expending time and money to learn things you may not use

SUMMARY

In this chapter, we have discussed the definition of a financial model, and determinedthat, at a basic level, a financial model is really just a complex spreadsheet that containsinputs and outputs in a dynamic way However, not every spreadsheet could be called afinancial model Models in Excel can be built for virtually any purpose, both financialand non-financial, business or non-business, although the majority of models will befinancial- and business-related—and these are the kinds of examples we will mainlyfocus on

Although this book is about how to use Excel in the context of business analysisand financial modelling, consider that there are many other available modelling toolsbesides Excel, including Microsoft products, add-ins, and third-party software Excel isthe most commonly used software for this type of analysis, and in terms of buildingyour skill set, improving your Excel skills will always stand you in good stead for acareer in finance

Having good technical Excel skills is not the only attribute of a good financialmodeller; industry knowledge, accounting, business acumen, design skills, communi-cation, logic, and numeracy are also important Modellers will have all of these skills invarying degrees, so think about which skills you need to work on the most Going to atraining course; using and taking apart others’ models; reading specialist publicationsand blogs; and using other online resources are all great ways to improve your financialmodelling skills

CHAPTER 2

Building a Model

structure, layout, and planning A thought-out design and clear project plan canmake a huge difference to the quality and success of the modelling project

MODEL DESIGN

Design can sometimes be the most difficult part of building a financial model and, in

my experience, one of the most difficult to teach and learn The best way to developdesign skills is to critically assess other people’s models, taking note of what works anddoesn’t, and then applying it to your own models

Even the simplest models can become complex if poorly designed, and a designed model will be so straightforwardly logical that it will simply speak for itself.It’s pretty easy to just dive in and start building a model without thinking aboutthe implications of the design It’s not a bad idea to spend some time thinking about thelayout before you get started The layout and structure of the model relate to the lookand feel of the model, and how users navigate through the model

well-The following examples outline a couple of different challenges you might comeacross when designing the layout of a model

Practical Example 1—Assumptions Layout

Let’s say you are creating a high-level five-year forecast We’ve got 15,065 customers

in 2013, and we are expecting that number to increase by 5 percent every year Ifyou set up your model as shown in Layout Option 1 in Figure 2.1, with only onegrowth assumption, you’re very much restricted to a single input for the growthnumber

If we change the design of the calculations by adding multiple input assumptioncells, and change the formula just a little, we are making our model a lot more flexibleand useful in the long term This way if we decide to change the growth number foreach year, as shown in Figure 2.2 below, we won’t need to change any of our formulas

in the future, and our model is much more robust and less prone to error

Of course Layout Option 2 is slightly more complex, but is more functional for theuser This example demonstrates the constant balance that a modeller needs tomaintain between functionality and simplicity when building a financial model

Practical Example 2—Summary Categorisation

Arranging products to display into categories in a model is another potentially difficultmodel layout problem Let’s say you’re creating a pricing model for some advertisingproducts You’ve got print ads and digital ads, and these are both split into Display andText Only The question is, should you display the output of the model as shown inFigure 2.3 or Figure 2.4?

The example in Figure 2.4 is more concise, but shows less detail, so it reallydepends on how much detail you want to show your user This comparison demon-strates the constant balance that a modeller needs to maintain between detail andconciseness when building a financial model

THE GOLDEN RULES FOR MODEL DESIGN

There are a few rules for model design that should be followed when designing thelayout of a model Most experienced modellers will follow these instinctively, as theyare generally common sense

Separate Inputs, Calculations, and Results, Where Possible

Clearly label which sections of the model contain inputs, calculations, and results Theycan be on separate worksheets or separate places on a given worksheet, but make surethat the user knows exactly what each section is for Colour coding can help withensuring that each section is clearly defined

See the forthcoming section titled “The Workbook Anatomy of a Model” for morediscussion on whether it is always practical to separate these sections

Use Each Column for the Same Purpose

This is particularly important when doing models involving time series For example, in

a time-series model, knowing that labels are in Column B, unit data in Column C,constant values in Column D, and calculations in Column E, makes it much easierwhen editing a formula manually

Use One Formula per Row or Column

This forms the basis of the best-practice principle whereby formulas are kept consistentusing absolute, relative, and mixed referencing, as described in more detail inChapter 3, “Best Practice Principles of Modelling.” Keep formulas consistent when

in a block of data, and never change a formula halfway through

FIGURE 2.3 Model Categorisation Option 1

FIGURE 2.4 Model Categorisation Option 2

Refer to the Left and Above

The model should read logically, like a book, meaning that it should be read from left toright and top to bottom Calculations, inputs, and outputs should flow logically to avoidcircular referencing Be aware that there are times when left-to-right or top-to-bottomdata flow can conflict somewhat with ease of use and presentation, so use commonsense when designing the layout By following this practice, we can avoid having cal-culations link all over the sheet, which makes it harder to check and update

Use Multiple Worksheets

Avoid the temptation to put everything onto one sheet Especially where blocks ofcalculations are the same, use separate sheets for those that must be repeated to avoidthe need to scroll across the screen

Include Documentation Sheets

A documentation sheet where assumptions and source data are clearly laid out is acritical part of any financial model A cover sheet should not be confused with anassumptions sheet Document, document, document!

DESIGN ISSUES

Here are four key issues you need to think about before you start a model

1 Time Series: Most financial models include a time-series element, and the majority

of these will be either monthly, quarterly, or annual It’s important to get this rightfrom the start, as it’s much easier to summarise a monthly model up to an annualbasis than it is to split an annual model down to a monthly basis!

2 Data Collection: Often the majority of time is not spent building a model, butrather collecting, interpreting, analysing, and manipulating data to put into themodel For example, you could be building an annual model for your company’sfiscal year, which goes from July 1 to June 30, but the survey data you’ve collectedand want to include is for the period January 1 to December 31 If you’ve gotaccess to the raw data on a monthly basis, you’ll be able to manipulate the data sothat it’s accurate—or else you’ll need to extrapolate

3 Model Purpose: Think about what it is that you want the model to do Whatoutputs do you expect the model to show? See “Types and Purposes of FinancialModels” in Chapter 1 for more detail on different types of financial models Theoutcome that you want the model to show will greatly influence the design ofthe model For example, in a business case or project evaluation model, the out-come that we are working toward is the net present value (NPV), and in order toget that, we need cash flow, for which we need a profit-and-loss statement, andthis then determines how we build the model

4 Model Audience: Who will be using your model in the future? If it’s for only youruse, no need to make it very fancy, but most models are built for others to use If so,you will need to make your model as user-friendly as possible, and clearly definewhich cells are input variables and which cannot be changed If you expect users tohave limited knowledge of Excel, the model needs to be as simple to use as possible

THE WORKBOOK ANATOMY OF A MODEL

Typically, modellers will work from back to front when building their model.The output, or the part they want the viewer or user to see, will be at the front, cal-culations will go in the middle, and source data and assumptions should go at the back.Figure 2.5 shows an example of what your model structure might look like

Like the executive summary, a board paper, or other report, the first few pagesshould contain what casual viewers need to see at a glance If they need furtherinformation, they can dig deeper into the model

Unless a model is very small, there should be a dedicated tab worksheet for eachmajor component of the model Whilst by no means a prescriptive list, below is anexample of what might be included on each tab:

not a cover sheet is necessary is an issue for debate, but one can include (but is notlimited to) details such as:

n A log of changes and updates to the model with date, author, change details, andtheir impact to the output of the model This is important for version control

n Disclaimers as to the limitations of the model, legal liability, and caveats

n Input Sheet: This is the only place where hard-coded data is permissible There may

be one or more input sheets if there are copious amount of data, but the input datashould be laid out in logical blocks, for example: consumption data, WACC data,assets and depreciation data, inflation and indices, pricing and tariffs, assumptionsand constants (such as tax rate, discount rates, concession rates)

also contain scenario drop-down boxes, spin buttons, or tick boxes that allow theusers of the model to generate their own outputs Tables and charts summarisingthe outputs should be set up in such a way that they can be easily printed or used togenerate reports Ensure that these can be easily printed directly from the model, orcopied or linked to other programs such as Word or PowerPoint

within each sheet, set them up consistently If calculation sheets are split, ensurethat the layout and formatting are as consistent as possible across all sheets

n Error Check Sheet: This sheet contains links to all error checks in the model Errorchecks should be performed in the calculation section, but a summary of all errorchecks in one location means that once the model is in use, the modellers canquickly check to see if any of the error checks have been triggered

FIGURE 2.5 Model Structure

Workbook Anatomy Issues

Matters to consider when designing the layout and structure of the model include:

n A Cover Sheet: Is a cover sheet necessary? It’s not absolutely critical, but it is goodpractice to put one in In my experience, cover sheets and instruction pages arerarely used If you decide not to include a cover sheet, make sure that the modelcontains explicit instructions regarding operation, purpose, assumptions, sourcedata, and disclaimers

n Input and Output Locations: Should there be a dedicated input sheet, or should theinputs and outputs be contained in one sheet? Many modelling specialists maintainthat inputs, outputs, and calculations must be clearly separated, but this is notalways practical Generally, larger models should have a dedicated input sheet,whilst smaller models may show inputs and outputs on the same sheet However, ifyou’ve created a large model with inputs and outputs on different sheets, and thenwant to perform a scenario analysis using a data table, you’ll need to move theinputs and outputs to the same sheet For example, in a small model thattakes inputs and generates simple tables of output data and charts in reports, themodeller may set up the sheet to have a block of input at the top of the worksheetwith the calculations and charts directly underneath You may consider splittingthe charts and ratio calculations into separate worksheets to avoid the worksheetbecoming too long and unwieldy

Depending on the size of the model, all calculations could be contained within oneworksheet, spread over several worksheets, or even spread over several workbookfiles If the calculations become long and confusing, it makes sense to split theminto logical sections For example, they can be split by type of service, customers,financial tables, geographical location, or business segments

n Colour Coding: If you decide to use colour (and I’d recommend that you do, or elseyour model will look pretty boring), make sure that the colours you use are con-sistent For example, if African regions are yellow, Europe is blue, and Asia is pink,make sure that you use those same colours every time numbers for Africa, Europe,and Asia are displayed These colours should be consistent in calculations in yourmodel, display tables, and charts Some companies have standard colour coding,but if your company does not, you might consider developing a standard Youcould consider including a colour code key in the cover page The use of predefinedstyles (found on the home tab) can make colour coding very quick and easy Beloware some commonly used colour codes that you may consider adopting in yourcompany:

n Blue font and beige background for input cells

n Pink or grey for error checks

Use a double border to indicate that the calculations change In Figure 2.6, thedouble line shows that the formula is not consistent across the row

Many companies have their pre-defined colour coding loaded as style templates,which ensures consistency in colour coding in financial models